Inflation affects us every day. Rising food prices, higher gas prices, and higher clothing costs are just a few of the examples of inflation. It’s easy to see these examples because we deal with them in the day to day. The effect inflation has on our investments is another story. While you look at your annual 401(k) statement and see that you earned 6% last year, that number is not completely accurate. That number is a pre-inflation number. If inflation is 2%, your real rate of return is only 4%. Inflation “ate away” 2% of your earnings.
On the same note, look at your savings account which is currently earning 1%. With inflation running close to 3% currently, you are actually losing 2% per year on your savings. You still have the same amount of money in the account, but the purchasing power of that money has decreased 2%. What is an investor to do to earn a higher return?
Treasury Inflation Protected Securities (TIPS) are long term bonds issued by the U.S. Government. In other words, they are loans to the U.S. Government. Investors who invest in TIPS are trying to preserve their purchasing power by limiting the impact of inflation.
Most bonds pay interest out every six months and that payment amount is fixed. If you purchase a bond with a 6% coupon, you are looking at $60 in interest payments in a given year. With TIPS, you still get interest payments twice per year, and the interest rate remains fixed. The only difference is that the payment you receive will fluctuate based on inflation.
How TIPS Work
The interest rate of a TIP bond will be slightly less than an equivalent bond. This is because the TIPS principal is adjusted twice per year according to the Consumer Price Index (CPI), which measures inflation.
For example, let’s say you buy $20,000 of TIPS that pay 2.5% interest. Over the next six months, the annual inflation rate rises at 3%. Your principal would increase from $20,000 to $20,300. This is an increase of 1.5%, which is half of the annual inflation rate. The reason it only goes up by half is because we only looked at the previous six months.
So your principal amount just increased, what about your interest payment. As stated before, the interest rate on TIPS is fixed, but the amount of interest you receive will vary. Originally on the $20,000, the interest received was $250 (20,000 x 2.5% /2). But now, your semi-annual interest payment is $253.75 (20,300 x 2.5% /2). While this sounds great, realize that if inflation decreases, your principal will be adjusted as well, this time, to the downside.
Determining if TIPS Are Better
Just because TIPS have an inflation feature, that does not make then a better investment. You need to do some basic math to determine if they are a good investment. Here is how you do that: Simply subtract the interest rate of a TIPS bond from the interest rate of an equivalent non-TIPS bond. If the current inflation rate is higher than the difference, then you should invest in TIPS. Here is an example. You are looking at two 10 year bonds, one being a TIPS bond. If the interest rate on the TIPS bond is 3% and on the non-TIPS bond it is 5%, then inflation needs to be higher than 2% (5% subtracted from 3%) to make the TIPS bond worth investing in.
Things To Consider Before Buying TIPS
TIPS seem like a great investment, but like any investment, they can lose money. If inflation is lower than what you anticipated, a non-TIPS bond most likely performed better than the TIPS bond.
Also, all of the above assumes you hold the TIPS bond to maturity. This means you do not sell the bond until the term is up. If you do sell before maturity, you will not receive face value for the bond.
One last thing to consider with TIPS is taxes. Tax is due every year on interest and any increases in principal. Realize that even though your principal amount changes every six months, you don’t receive that money until the TIPS bond matures. The IRS however, treats that increase as if you actually received the cash in the year of the increase. In other words, there is a decent amount of paperwork to deal with in regards to TIPS.
I am not recommending you rush out and buy TIPS. You need to determine if they are a good fit for your goals and objectives. As always, careful consideration should be given to any investment.